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The Best Way to Prepare for the Coming Market

News flash: You can learn a lot from history.

"The past is not dead. In fact, it's not even past."-- William Faulkner

On Oct. 5, 1930, Alexander D. Noyes, then the financial editor of TheNew York Times, reflected on the American economy a year after the great stock market crashes of October 1929. It began:

We have come to a curious turn in the economic road. Things have happened during the past 12 months in our financial and economic history that we had taught ourselves to believe would never happen again.

It sounds eerily familiar, doesn't it? But it gets better. He continued:

We had contrived new formulas for expanding credit which were to make us independent of the vicissitudes and insecurities of other periods. ... One of the cardinal maxims of the last three years had been that the "business cycle" was abolished; if, indeed, it had not always been a myth.

Sadly, those words strike a chord with us almost 80 years later. Indeed, if you replace Noyes' early 20th-century references with 21st-century ones, you could swear he was writing today.

Those who do not learn from history ...In the course of those 80 years, some three generations of Wall Street brokers, analysts, and investors have come and gone. It shouldn't come as a surprise, then, to find that some crucial lessons of the Great Depression were largely forgotten or disregarded by Wall Street -- with tragic consequences.

Despite the fact that our economy has experienced a number of recessions and several periods of volatility since those years, we didn't think we would again see iconic banks like Bank of America(NYSE:BAC) and well-respected regional banks like Fifth-Third Bank(NASDAQ:FITB) stumble, nor did we believe we would ever see vaunted global insurers like AIG(NYSE:AIG) scrambling for survival.

Why? Because we have powerful government agencies and Depression-era legislation to protect us against full-scale financial disaster. We have bond-rating agencies like Moody's and Standard & Poor's to verify the financial health of CDOs issued by UBS(NYSE:UBS) and other reputable banks. Fannie Mae(NYSE:FNM) and Freddie Mac were set up to maintain order and affordability in the mortgage market.

We thought we had, as an economy, learned those lessons. Unfortunately, all of these agencies failed us miserably over the past decade, either from apathy, impotence, ignorance, corruption, or some combination of all four.

We also failed ourselves. As a society, we should have known better than to overleverage our personal finances with mortgages we couldn't afford and overcharge credit cards issued by the likes of American Express(NYSE:AXP) and Capital One(NYSE:COF) that we couldn't repay. True, some people were genuinely taken advantage of by unscrupulous mortgage brokers, Realtors, and other salespeople -- but such sales tactics are nothing new. In fact, the very same thing happened in the 1920s:

It was no new idea for energetic salesmen to persuade the customer to buy more than he had meant to buy, perhaps more than he thought he could afford. "Intensive salesmanship" is as old as the [18]50's, but it was certainly never carried to the extremes of 1928 and 1929. The picture presented in the three or four year period before last October was of consumers who were taught, with immense success and with great applause from Wall Street, to buy with money which they did not have.

The parallels are clearer and clearer.

... are doomed to repeat it?When Noyes was writing, the full scope of the Great Depression was yet to befall the country -- but many of the elements in play then look very familiar: rising unemployment, a government struggling to respond, and a financial system in shambles.

He was encouraged, however, that Americans in 1930 had already begun to discard "completely the dangerous illusions of the past two years and making ready to meet and turn to the American community's advantage whatever realities may be ahead of us."

Something similar seems to be happening today. In fact, in the three months ending in December, American household debt decreased by 2% -- the first decrease on record -- and the personal savings rate is 5% -- the highest level since 1995. That trend is likely to continue, regardless of the government's many efforts to pump more credit into the hands of consumers. While massive de-leveraging is bad for the economy in the near term, it's what we desperately need if we're to return to healthy economic growth over the long run.

Writing a different futureIn the 10 years following Noyes' observations, the stock market remained a roller coaster and, despite some hopeful rallies, never even came close to the highs of October 1929. Indeed, the market's total return from 1931 to 1940 was essentially zero, despite the significant volatility it endured in the meantime.

While I'm not going to try to predict the near-term market, it would serve us well to consider the possibility that the market will provide lackluster returns in the coming years. That makes learning about all of the tools at our disposal -- tools that can help you generate more income, reduce your portfolio's volatility, and increase the benefits of diversification -- even more important.

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This article was first published on Dec. 26, 2008. It has been updated.

If worst comes to worst, Pro analystTodd Wenningwill raise rabbits and live off the fat of the land. He does not own shares of any company mentioned.American Express and Moody's are Motley Fool Inside Value recommendations. Moody's is also a Stock Advisor choice. The Fool owns shares of American Express. The Fool'sdisclosure policyis neither a mouse nor a man.